As someone who understands some things about models, psychology, mathematical physics, theoretical finance, arbitrage, and trading in real markets, I will admit that beat-the-market trading systems can be invented.  Even the hardliners in financial theory have softened their stance on the efficiency of modern investment markets, as one after another so-called anomaly was discovered by the academic world (professional investors had know it all along).  However, I will further state that any so-called trading system that can consistently garner excess profits, if shared with the public or any larger number of other actors in the market, will lose its ability to earn excesses.

If the academics focus on the sterility of rational financial theory in application to real markets, the average man on the street is still convinced that get-rich-quick schemes really exist.  The truth lies somewhere in the middle ground.  Indeed, over the past thirty years, just after the Efficient Market Hypothesis and around the time of Black Scholes, another branch of finance began to develop.  In Behavioral Finance, the focus is on the fact that people are not actually the rational machines on which financial theory, as begun by the mathematical physicist, John VonNeumann, in the early part of the twentieth century.  That new hypothesis, alone, means that there will be overreaction and underreaction, leading to mispricing.  Of course, a corollary of that implication is that, if you understand how people will act irrationally and under what conditions, then, you will be able to take advantage of those situations and, again, make excess returns.

However, the continued effectiveness of such excess-profit strategies depends on their being kept secret, which may not be an easy task.  Even though you might never tell anyone about your system, at the least, the people who execute your orders to buy and sell will see your order flow and might realize that you continually take on winning positions.  That can be an especially salient problem, if, for example, you manage a large quantity of money.  When I traded in merger arbitrage, we, in the business, often used multiple brokers to execute our orders, so that it would take people a longer time to figure out that one entity was accumulating a large position.

In the end, anyone who knows about your system will replicate your actions, and, therein, lies the rub.  Market prices are affected by buying and selling.  There will always be only a limited supply of an investment asset, like stock or gold.  Thus, there will be only a limited amount being either bid for or offered at various prices.  For example, there might be 10,000 shares of ABC offered at $50; 15,000 offered at $50.25; 25,000 offered at $50.30; 30,000 offered at $51.  If you are the only one who knows your trading system, and the proper place to buy is at $50, you can execute your strategy, if you want 10,000 shares or less.  However, if other people know your system, they may all put in orders to buy and push the stock up to $51, which is 2% higher and may represent a price that no longer offers an excess return.

There are two more truths of the investment business that go hand in hand with what was demonstrated in the above example.  First, arbitrage is a general trading strategy to find misaligned prices among even disparate instruments and markets and initiate simultaneous buying and (short) selling to take advantage of the misalignments.  An easy example is in the foreign exchange markets and is called covered interest arbitrage (CIA).  In that regard, if you can earn 7% in six-month riskless bonds, in country X but only 3% in country Y, you could exchange currency Y for X, in the spot market, invest the money in X-bonds, and enter a six month forward contract to buy currency Y for X.  The key to the viability of that strategy is the price of the forward contract.  In reality, the forward contracts, in this situation, will eventually, if not immediately, be priced so that there will be no interest rate advantage.  If they were not, arbitrageurs would take on the chain of positions, described above, and reap a riskless profit.  In fact, the number and description of possible arbitrages, like this, are as numerous as the imagination can come up with, and the point is that as people recognize these riskless opportunities to profit, there buying and selling of the various components will eventually wipe out the excess benefit.

The second factor that we alluded to, above, is that as more and more non-professionals become aware of an excess-profits trading strategy, their inexperience will make matters even worse.  In that they do not fully understand all of the technicalities involved in a particular trading strategy, it has been observed that they tend to overpay and undersell, taking the original results of the strategy past the point that a professional arbitrageur would, making the eventual results even less than normal profits.  I have seen that happen, for example, in my old business, merger arbitrage, over the last several decades, and the business has become so unprofitable, in general, that, by now, all of my friends and I have exited the business.

Another type of trading “system” that I have observed over the last decade plus is not a system at all but is closer to a pyramid scheme.  In that regard, since the advent of on-line trading and message boarding, there are many self-styled investment “gurus” who post buy and sell recommendations on message boards or, now, on twitter.  Even back as far as the 1980’s, there were people who would spread rumors about certain stocks.  Their underlying motives were that they already had a position, long or short, in a stock, and as the rumors spread, the stock price would move in a direction that made profits for them, and they would unload their positions at a profit.  For the past decade plus, this type of thing has been made even easier with on-line message boards and trading.  If they can get enough people to believe that what they are saying is true, the actions of those followers will create momentum in the stock (or other investment instruments) and make their musing reality.  Moreover, they will gain credibility with their followers because what they recommend seems to always come to pass.  In my opinion, it is that type of pyramiding, rumor-mongering that has been responsible, at least in part, for the incredible bubbles in the NASDAQ, in the late 1990’s, and, more recently, in the Chinese stock markets.  Moreover, in my opinion, it is tantamount to forming an unregistered group, which is illegal under the securities laws, and I hope that, someday, the SEC and other securities commissions will act to do something about it.

That people fall into these traps, in the first place, is that they believe that get-rich-quick schemes do exist, while I believe that they do not: hard work and creative ideas will make you rich.  The people who offer such systems, in my opinion, are preying on hopelessness, desperation and greed.  It is what has always made con games possible.  You might make money for a while, but, if you look at what happened to all of those people who “played” the hot NASDAQ, in the 1990’s, or the Chinese stock market, in the last few years, you may begin to realize that it can also leave you much worse off when the party is over: the NASDAQ lost 80%, and the Chinese stock market lost around 70%, in the end.  I advised people to get out of the Chinese stock market over two years ago; those who did, thanked me; those who didn't, lamented.

You can read some more of the things that we have written about investment, on this blog and, also, at:
The In-Country Analysis page of our website http://www.leonacraig.com/In_Country_Analysis.htm
Red Hill China Blog http://blog.redhillchina.com
Ezine Articles http://ezinearticles.com/?expert=Craig_Mattoli 
Buzzle http://www.buzzle.com/articles/china-exports-purchasing-power-arbitrage.html 
Article Base http://www.articlesbase.com/investing-articles/contrarian-investment-strategy-as-pe-arbitrage-845377.html 

Craig Mattoli, CEO Red Hill Capital Corporation, Delaware  © 2009